Meaning of Sharpe Ratio

Investors use the Sharpe Ratio to assess the investment's performance. It is used to compare the return on an investment to its risk.

What is the Sharpe Ratio?

The Sharpe Ratio, also known as the excess or risk-free return, is the difference in return from an investment and the return on the investment. It is divided by the standard deviation. With the Sharpe Ratio, the investor can assess if the investment meets his needs. This adjusts the investor's excess risk to the investment's performance. It is used to compare the performance of shares against their risk. Sharpe Ratio allows investors to compare funds with the same risks and returns, or to a benchmark. This can help them understand how well they will be compensated.

How do you calculate the Sharpe Ratio

Sharpe Ratio = Rp-Rf/ Standard Deviation for the fund return

Where?

Rp = Return on a Portfolio

Rf=risk-free rate

The Sharpe ratio is a measure of risk. The standard deviation represents the relationship between them. This is also called the total risk. If both funds return the same amount, shares with higher deviations will have a lower Sharpe Ratio.

What is the significance of Sharpe Ratio?

The Sharpe Ratio is a measure of how much an investor can receive for investing in risky stocks rather than in risk-free stocks. This ratio can be used for estimating the extra profit an investor could make by holding high-risk assets in the market. A stock with a high Sharpe ratio will have higher returns than the investment risk it took. Negative Sharpe ratios can indicate that the stock's risk-free rate exceeds the stock's expected return or that the stock's return will be negative. In these cases, it is better to invest in a risk-free investment than in a high-risk one. A risk-free asset has a Sharpe ratio of zero.

If the portfolio has low to negative correlations, it can reduce portfolio risk and increase Sharpe ratio.

Limitations on Sharpe Ratio

The Sharpe Ratio cannot be used alone as it doesn't provide enough information. This ratio must be calculated by comparing funds with other funds or a benchmark. The standard deviation is the distribution of returns as it occurs. It is not as useful if the distribution is asymmetrical. Portfolio managers can manipulate Sharpe ratio to increase their history of risk-adjusted return. Sharpe ratio does not distinguish between upside or downside. It focuses only on volatility and not its direction. This means that price movements in any direction can be equally risky.